Suppose you have been hired as a financial consultant to Defense Electronics, In

Question

Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $7 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the land were sold today, the net proceeds would be $7.7 million after taxes. In five years, the land will be worth $8 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $13.4 million to build. The following market data on DEI’s securities are current: Debt: 46,000 6.8 percent coupon bonds outstanding, 20 years to maturity, selling for 94.0 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 760,000 shares outstanding, selling for $95.00 per share; the beta is 1.19. Preferred stock: 36,000 shares of 6.2 percent preferred stock outstanding, selling for $93.00 per share. Market: 7 percent expected market risk premium; 5.2 percent risk-free rate. DEI’s tax rate is 35 percent. The project requires $875,000 in initial net working capital investment to get operational.

Requirement 1: Calculate the project’s Time 0 cash flow, taking into account all side effects. Assume that any NWC raised does not require floatation costs. (Do not round intermediate calculations. Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).) Initial Time 0 cash flow $

Requirement 2: The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Requirement 3: The manufacturing plant has an eight-year tax life, and DEI uses straightline depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $1.6 million. What is the aftertax salvage value of this manufacturing plant? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Requirement 4: The company will incur $2,400,000 in annual fixed costs. The plan is to manufacture 14,000 RDSs per year and sell them at $11,400 per machine; the variable production costs are $10,600 per RDS. What is the annual operating cash flow, OCF, from this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).)

Requirement 5: (a) Calculate the net present value. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) Net present value $ (b) Calculate the internal rate of return. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

Answer: Requirement 1:

The initial cost to the company will be the opportunity cost of the land, the cost of the plant, and the net working capital cash flow, so:

CF0 = –$7,700,000 – 13,400,000 – 875,000 = –$21,975,000

Answer: Requirement 2:

The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $7.7 million appraised value of the land is an opportunity cost and is relevant. The relevant market value capitalization weights are:

MVD = 46,000($1,000)(0.94) = $43,240,000

MVE = 760,000($95) = $72,200,000

MVP = 36,000($93) = $3,348,000

The total market value of the company is:

V = $43,240,000 + 72,200,000 + 3,348,000 = $118,788,000

Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

RE = .052 + 1.19(.07) = .1353 or 13.53%

The cost of debt is the YTM of the company’s outstanding bonds, so:

P0 = $940 = $34(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 3.69%

YTM = 3.69% × 2 = 7.38%

And the aftertax cost of debt is:   

RD = (1 – .35)(.0738) = 4.797%

The cost of preferred stock is:

RP = $6.2/$93 = .06666 or 6.67%

To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:

The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 3 percent, so the required return on this project is:

Project required return = .1016 + .03 = .1316 or 13.16%

Answer: Requirement 3:

The annual depreciation for the equipment will be:

$13,400,000/8 = $1,675,000

So, the book value of the equipment at the end of five years will be:

BV5 = $13,400,000 – 5($1,675,000) = $5,025,000

So, the aftertax salvage value will be:

Aftertax salvage value = $1,600,000 + .35($5,025,000 – 1,600,000) = $2,798,750

Answer: Requirement 4:

Using the tax shield approach, the OCF for this project is:

OCF = [(P – v)Q – FC](1 – t) + tCD

OCF = [($11,400 – 10,600)(14,000) – 2400,000](1 – .35) + .35($13.4M/8)

=$5720000+$586250

= $6,306,250

Answer:5 (a) NPV:

We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value, the recovery of the initial NWC, and the aftertax value of the land. The cash flows for the project are:

(b) IRR:

Capital structure Market value Weight Cost of capital WACC Debt 43240000 0.36401 4.797% 1.75% Common shares 72200000 0.60781 13.53% 8.22% Preferred shares 3348000 0.02818 6.67% 0.19% Total 118788000 10.16%

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